China&rsquo;s Bear Threat Isn&rsquo;t Over

The squeeze is on in China’s real-estate market, which means slow going for the near future. I still like China stocks, but I’m steering clear for now.

The Shanghai stock market recovered a bit—a tiny bit—in trading on December 28, and then edged ahead again on December 29. That two-day advance was the first time in a month that the Shanghai Composite Index has strung together two back-to-back gains.

But apart from those moves, the low of 2,174 on December 29 marked the lowest point for the Shanghai Composite Index since March 16, 2009, when the index closed at 2,154.

Forget about the October 20, 2011 low at 2,331—that’s 7% above the current market. And the November 3, 2010 high at 3,161? Well, the Shanghai market is down 31% since then.

The next stop of significance would be the November 2008 low at 1,720. That’s 450 points below where we are today—or a 20% drop from today’s index level. A move back to 1,720 would mark a huge 46% plunge from the November 2010 high.

Why is the Shanghai market still falling, even though it looks like the People’s Bank of China is starting to loosen its monetary policy? Why am I even contemplating a 45.6% superbear for Chinese stocks?

Here’s why.

The Squeeze Is On
At the recently concluded annual Central Economic Work Conference, China’s political leaders and top economic officials decided that the government would continue to squeeze the housing sector until prices returned to "reasonable levels."

What’s reasonable? Well, the work conference didn’t define the term. But a recent report from the Agricultural Bank of China, one of China’s state-controlled banks, has fleshed out what "reasonable" might mean for housing prices in China’s cities.

The numbers aren’t pretty: Housing prices in China’s most developed, first-tier cities (Shanghai and Beijing, for example) would need to drop an additional 10% to 25%. Prices in second-tier cities would need to drop 5% to 15% more.

The bank got to these numbers by looking at a 1998 survey by the United Nations of housing affordability in 96 countries. To be "reasonable," the bank concluded, prices should be six to eight times the average level of household income in China. (The bank, to its credit, assumed that China’s average household income is 1.5 times the official figure from the National Bureau of Statistics.)

You can certainly pick holes in the Agricultural Bank of China’s methods, and the extent of the decline to "reasonable" is only a rough estimate. The important thing from the work conference and the bank’s report is the conclusion that the government is serious about continuing the current pressure on housing prices.

The work conference’s concluding statement said the government would "unswervingly adhere to real-estate control policies."

You can understand why this has kept the pressure on the stocks of property developers such as Poly Real Estate and China Vanke. Total housing starts could fall 15% in 2012, according to UBS.

The fear for China’s stock market as a whole is that a slowdown in the real-estate sector will ripple out through the rest of the economy, creating a slowdown that the government can’t counter before the country comes in for the dreaded hard landing.

A Housing-Driven Economy
The residential real-estate sector itself accounts for 6.1% of China’s gross domestic product, but investment in the sector drives demand for everything from cement to copper to construction equipment to home furnishings.

Rising prices for residential real estate help drive up land prices—and because land sales are a critical source of revenue for local governments, rising land prices help pay for local infrastructure development, education, health care, and business investment.

This connection between local revenue and real-estate prices is especially important, because China’s official stimulus policies often rely upon local governments to provide the cash to fulfill directives from Beijing.

Any attempt to put a figure on the extent of real estate’s actual share of China’s GDP is just an estimate—15%? 20%? But you can see why investors and economists might be worried about the impact of a continued policy of reducing real-estate prices, and about the ability of the central government to make up for the shortfall.

The worry among investors isn’t that the government in Beijing is unaware of the danger, but that it won’t be able to avert it. So, for example, there’s been talk of a tax cut to stimulate consumer demand.

But a tax cut wouldn’t have the power in China that it might in the United States. It’s one thing to say the government will stimulate consumer spending with tax cuts that put more money in the hands of consumers in the United States, where consumer spending makes up 70% of GDP, and it’s quite another to say it in China, where consumer spending makes up just 35% of GDP.

The People’s Daily has reported that the country will spend 200 billion yuan ($32 billion) on constructing rural roads through 2015. That would be more than the total for the previous five years, it’s true, but it’s less than the country spent on its big infrastructure splurge after the Lehman Brothers bankruptcy. I also wonder if strapped local governments will be able to kick in their usual big share of spending mandated by Beijing.

There’s also widespread conviction that the People’s Bank will cut reserve-ratio requirements again—by an additional 0.5 percentage points—after New Year’s. (A reserve-ratio cut was the subject of a front-page editorial in the government-controlled China Securities Journal on Dec. 29.) That projected cut would be on the heels of the cut that took effect on December 5.

Each half-percentage point cut frees up about $50 billion that banks can lend rather than keep as reserves. But China’s money supply expanded by just a 12.7% annual rate in November, the slowest in a decade, so any monetary stimulus from reserve ratio cuts has a lot of ground to make up.

The government has also approved a new quota for Qualified Foreign Institutional Investors, the first since May, which will bring new money to China’s financial markets. Still, a skeptic might note that the additional quota of $950 million still leaves the total amount of foreign money that can be invested in China’s financial markets at just under $22 billion.

The Drop Isn’t Over
For all these reasons, as attractive as prices of China’s stocks are right now—a 31% drop from the November 2010 high is a significant drop—I’d wait before making a big move into Chinese equities.

I’d certainly wait until after the Lunar New Year/Spring Festival, when liquidity improves. That holiday comes early this year, in late January.

Waiting even longer is probably a good idea. Let the fear of a hard landing as a result of falling real-estate prices play out for a quarter or more. Let GDP growth slow some more. Let the People’s Bank loosen monetary policy some more. Let investors start to think that an actual interest-rate cut is likely for June or July.

I still like Chinese stocks—it’s just that I like them for the middle of 2012.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. For a full list of the stocks in the fund as of the end of September, see the fund’s portfolio here.